Shareholder Wealth and Corporate Risk Management

Corporate risk management is a practice to optimize the risks in business operations and investing. The business leaders are responsible to control and management the risk to strengthen the business and maximise the shareholders wealth.

A business firm can have various types of risk, however, a firm which has international business have almost all the time there is a risk of foreign currency exchange risk. Unexpected exchange rate would change the value of the company. It could either be a gain or loss to the firm as well as to the shareholder.

Identifying potential sources of trouble, analysing them and taking necessary steps to prevent the loss are a duty of a business leader. Do all the business leaders fulfil this duty? My view is only the leaders with sound financial knowledge and experiences are capable to follow due to the complexity of international finance and the risk involved.  

In order to measure the impact of exchange rate movement of a firm, it is important to understand the type of the risk the firm is facing at present. A firm could face three types of risks namely, transaction risk, translation risk and economic risk.  

Currency market is volatile. When the market is fluctuant, income derived from foreign operations/transactions could be affected. Similarly, a risk in translating company assets and liabilities in terms of home currency and foreign currency, therefore, the misinterpretation of the company could result the loss of potential investor and it could affect to the shareholders too. Unlike the transaction and translation risk, the economic risk is related to the currency determination. It is basically the risk to the firm’s present value of future operating cash flows from exchange rate movement. For example, oil prices are set in USD, if the USD strengthens against the Euro, the oil company should increase the price.

Being a fluctuation of foreign currency could cause a risk to business profitability, a business leader must prevent the loss to the shareholders and organisation, however, risks vary from a business to business, depending on the size, industry, diversity of business lines, source of capital, the practices to tackle the situation are differed.

To reduce or eradicate the risk, many business organizations consider the hedging as a tool. It could be done in number of ways such as offsetting the borrowing or lending at market rate or purchasing a forwarding exchange contract to a future date, hedging foreign currency options or position the funds through transfer pricing and etc. They all effectively serve the same purpose but slightly in different ways.

The recent various news are indicating the change of Japanese Yen and Latin America currency has affected the many business operations such as LG, Samsung and etc.   As per FiREapps 2013Q3 Corporate Earnings Currency Impact Report, the most top 5 industries were Medical equiptment & supplies, Auto, Chemical  Manufacturig, Biotech & Drugs and Services Business.

This evidence the impact of foreign currency exchange risk to an organisation, therefore, business leader should not ignore and identify the possible way to handle the situation.  Otherwise, the business could lead into failure and would have a severe affect to the shareholder wealth.

References:

http://www.hedgefundsreview.com/hedge-funds-review/news/2199858/analysis-uk-court-case-highlights-pitfalls-of-legal-tax-avoidance-for-hedge-fund-managers#ixzz2LlZ57sIg 

http://www.investopedia.com/articles/basics/03/080103.asp

 http://www.investopedia.com/terms/o/offshore.asp#ixzz2LkMub8ht

http://www.investopedia.com/terms/o/offshore.asp#axzz2LjY7KQaG

http://www.investopedia.com/articles/forex/09/corporate-currency-risks.asp#axzz2LjY7KQaG

OCBC and Debt Financing

I had just completed the lecture on how businesses are financing to their business operations and their vision. This expands my knowledge span and it is quite interesting to learn how a business can be beneficial through debt financing or equity financing. As usual, there are pros and cons in applying one method, a business leader has to make a decision which method would be the most beneficial to his organisation.

To apply the knowledge I learnt into the real world business operation, I had looked into the FT newspaper and I have found interesting article about the recent sale deal between OCBC of Singapore and Wing Hang Bank from Hong Kong.

OCBC declared all of its buyout would be debt financing. The lenders are from Bank of American and HSBC.

First I wish to know about how they evaluate the value of a firm for financing purpose.

In general, a firm may have a number of financial resources such as common stock, preferred stock, debt and retained earnings. In purchasing a business always required to evaluate the risk too. In accounting practice, WACC calculation is used to identify the risk.  The above mentioned finance resources of a firm are the principal means of calculating the WACC.  Looking at WACC figure, the decision maker would understand the healthiness and worthiness of the business.

Analyst views differently on the price offered by OCBC.  Many analysts believe OCBC offer price is higher than actual value. In 2001, DBS bank had bought Dao Heng Bank at the price of 3.3 times to the book value and the return on investment did not meet the expectation. The analysts have doubt on the return as it would cost to the shareholders. Furthermore, the analysts believe OCBC should not pay the high price as a first time buy out.

 Offering higher price may have some influencing factors behind the scene. Therefore, it is rather going down to find out the level of offer, I wish to observe the reason of OCBC decision to finance the buyout in terms of debt financing plus the force behind to paying high price.

The chosen method will give an opportunity to OCBC for having more management control and it helps no additional shares to be issued in raising the necessary capital. But the disadvantage is the interest cost borne from the borrowed money and the liabilities from the previous owner. The market rumour saying OCBC will issue stocks to meet the short term loan liabilities.  After this rumour, it appears OCBC and Wing Hang stock prices fell too. In this scenario I wonder about the stock holder in OCBC.  Are they truly benefiting from the buyout?

The Wing Hang share price fall may benefit to OCBC as its buy out offering pattern comes 2 time of the book value of the company.  However, shareholders from OCBC will not be benefiting for a short term due to the share price fall and probably by the loss of dividend. This could be retaining the earnings or sharing dividend to the existing Wing Hang stock holders and the possible new stockholders. 

In addition, offering high price may give OCBC a leading market position in Hong Kong as well as in China which is a large potential market. The presence of branches in Hong Kong and China will reduce the unnecessary transaction charges for the customers who like to do business in China and it definitely will build the customer trust and confidence. Thus could result the out-performance  of the bank which is one of the determinants to bring the share price up. If it happens, I believe it is a win-win situation for every stakeholders involving in OCBC, the stockholder, the management and customers too.

Being all the parties involved are financial institutions so that they have the expertise in financial matter. Certainly it can be expected that they will carry out the buy out with due diligence.  

The real question is OCBC has learnt something from the DBS bank experience with Dao Heng Bank. Hopefully, OCBC may have a plan not to fall into the same trap as DBS Bank.  It is interesting to watch whether the deal is successful or not.

Reference:

http://www.themalaymailonline.com/money/article/ocbcs-bid-for-hks-wing-hand-raises-valuation-funding-concerns

http://www.thestandard.com.hk/news_detail.asp?art_id=141218&con_type=1

http://www.ft.com/cms/s/0/b285e73e-76aa-11e3-807e-00144feabdc0.html#axzz2tLXJX6HK

http://www.reuters.com/article/2014/01/06/ocbc-winghang-idUSL3N0KG0X120140106

Maximising and Creating Shareholder’s Wealth

As we all know, an agency is the relationship between two parties, where one is principal and the other is an agent who carries out the duties or transaction with a third party on behalf of the principal. In business term, the famous agency theory describes principal as shareholders and the other party becomes the management team who represents the shareholders.

Shareholders expect management to carry out on their behalf to create and manage a value where they invested. To carry out this duty, a company must have objectives and goal. These will create clear decisions for the management to lead the firm and it is more practical to everyone in the team where the company is leading. By understanding and following the right route will maximize the shareholder wealth.

Therefore, it is evident that the management is responsible to create a value which can maximise the shareholder wealth. However, in reality, giving an authority to control by management who are only paid staff, the principal “the shareholders” has an issue where the overconfident managers and their dysfunctional behaviour can cause adverse effect. It can even lead the shareholders to sell their shares and there is a potential threat to downfall of the share price. Not only this, if the management is emphasizing too much reliant on the short term success and let it happen the share price increase may result the failure in longer term, for example, six years result prior to downfall of ENRON whose image was boasted that the company had enjoyed good return.




Image Source : http://craneandmatten.blogspot.co.uk/2013/03/fun-facts-about-corporate-accounting.html

Therefore, it is important that the management must ensure to set both short term and long term objective separately. This will enhance the success of the business. Being management team is salaried staff and having a long term objectives, the experienced and skilled staff for example CEO and CFO should be retained. In order to carry out the objectives effectively, nowadays this is a common practice that these Executives are offered a compensation package in terms of higher pay, incentives and share option.

Last year, Barclays Bank had a hard time. They had committed miss-selling of PPI product to customers. The bank claimed their junior staff had done but it was difficult to believe the majority of junior staff could carelessly sell the insurance policies without proper management of the rules and regulations set by the bank authorities. Definitely, Barclay bank had benefited in shorter term with the revenue made from the miss-sold of PPI. However, in long term the bank had suffered the consequences. According to the Guardian Newspaper of 16th November 2012, Barclays Bank was costing bank times and cash to sort these miss-sold PPI reclaiming. This improper action which might be management decision or purely junior staff mistake (hardly believable) as they claimed had caused a bad image and costs to the investors in longer term.

A value can be identified as tangible and intangible. But whatever it is, both are important for the organisation. Wall Street Journal of Feb 2013 stated that Barclays Bank Chief Executive Antony Jenkins said Friday that he would give up his 2012 bonus to rebuild the bank’s image. He accepted the wrong doings of his predecessor and tried his best to recreate the intangible value of the bank he was responsible for.

Creating a value by a shareholder is varied and it could be from the amount invested or the required rate of return or the annual rate of return on capital. However, the main aim is to maximize his investment by choosing a right project. The common and key measurement is NPV Net Present Value of the investment he wishes to do. The investor/shareholders believe the higher the NPV is the better and maximizes the investment they have invested. Sometimes it is difficult to forecast for the longer term due to unforeseen circumstances such as inflation and the potential liabilities in future.

Hence a balance sheet, profit and loss account of a company does not tell the whole story of the company. To understand more about the company and its future prospect, many investors use other investment appraisal too such as EPS Earning per Share, ROCE Return on Capital Employed and etc. Alternatively, the investors are looking at the higher share value to a company in view of getting higher return as per Law of demand and Supply. However, the potential danger is data manipulation by the management like ENRON or setting the shorter term goals to raise the profit by totally ignoring effect on the longer term.

An investor may try his best to forecast on the investment return and at the same time, a company with a good management team have also tried their best to meet their business objectives. Despite of their effort and beyond their control, some unforeseen circumstances can destroy their creation of value in the company or investment.

The recent FT blogs about value creation and value destruction in Brazil is another good example of unforeseen circumstance. Flow of FDI Foreign Direct Investment to Brazil was increased and Brazilian portfolio assets were worth more than $260bn in three years from 2011 to 2013. This inflow of FDI could save the country economy, however, the value of assets held by foreigner fell and resulted a loss of $24bn, implying value destruction of more than $284bn in less than three year. The blames lies in global financial crisis of 2008 and 2009 and critics says it is the cause of Brazil State Capitalism and pointing out the changing roles of private sector and public sector banks.

Therefore, it is recognizable that these current issues in market make the increasing pressure on corporate executives to measure and manage the shareholder value on regular basis. Technically, it could be measurable with different approaches in terms of strategically and financially. Furthermore, it requires educating the managers and having an opportunity to participate in creating company values and increase the capability to maximize the profit. This will enhance to maximize the shareholder wealth too.

References:

http://www.theguardian.com/money/2012/nov/16/ppi-claims-handlers-barclays

http://online.wsj.com/news/articles/SB10001424127887323701904578277492464792404

http://blogs.ft.com/beyond-brics/2014/01/23/investing-in-brazil-value-creation-and-value-destruction/#axzz2s69E0ktS

My First Day on Blogger

Hello, My first day on Bloggger!